Friday, January 2, 2015

Jesse — The Great Fallacy at the Heart of Modern Monetary Theory

But here is the matter of disputation, emphasis in caps theirs, in italics mine. "The sovereign government cannot become insolvent in its own currency; it can always make all payments as they come due in its own currency because it is the ISSUER of the currency, not simply the USER."

Do you see what is missing here, and more importantly, what is implied?

What is missing is the acknowledgement that the users of a currency, call them 'the market,' can and will and have quite often throughout history questioned the valuation of a currency, and often to the point of practical worthlessness, if certain actions are taken by the sovereign in creating their currency.
This speaks to a principle that I spelled out some time ago, that the practical limit on a sovereign government in printing money is the willingness of the market toaccept it at a certain value. And this applies to any sovereign, more readily perhaps if they are smaller and weaker, but always given time nonetheless.

If Russia, for example, were to merely start printing more rubles and set a target valuation for them, they could enforce this internally. And in fact, many sovereigns have done so throughout history. I remember visiting Moscow shortly after the fall of the Soviet Union, and marveling at the disconnect between the official stated valuations and the actions of the ordinary people in seeking alternatives like the US Dollar, gold, diamonds, and even Western style toilet paper, a more useful sort of paper than the ruble…
Jesse mistakes insolvency for currency depreciation. They are not the same. Conflating them is a common error. Insolvency can result in currency depreciaton as savers shun the currency, but insolvency is not the only cause of depreciation. Instability is also a chief cause. This might be political instability, inflation, or falling fx rate as foreigners  reduce saving desire in the currency. for whatever reason.

A currency sovereign is not constrained operationally by insolvency although a currency sovereign may chose voluntarily to default, as Russia did in 1998. But this is a political choice, just as would defaulting on the US public debt owing to the voluntary political imposition of a debt ceiling.

Currency depreciation can occur for many reasons, some that are potentially under the government's control or ability to influence, and some not, such as capital destruction in wartime that reduces the potential of the economy, or the changing condition of the world economy that has led to the depreciation of the currencies of countries lacking broad and deep economies that are significantlly dependent on oil exports.

Insolvency is defined as the inability to meet financial obligations as they come due. The government of a nation that is sovereign in its currency and does not borrow in a a currency that it does not control cannot become insolvency. Balance of payments issues may arise but they affect domestic firms and the government itself unless it is liable for the debts of domestic firms. Clearly, a country that issues it own currency and floats the exchange rate cannot become insolvent in this sense, although the fx rate can plunge or inflation can ensue from imprudent policy thereby debasing the currency to the degree that there is currency flight. This, however, is not insolvency.

MMT economists claim that insolvency is not an operational constraint on a currency sovereign but both the foreign exchange rate and domestic price level are operational constraints that governments must take into consideration. For example, petroleum exporters Russia and Venezuela are both adversely affected by steeply falling oil price to the degree that their fx rates are plunging and inflation rate rising, provoking currency flight as holders of the currency no longer wish to save in these currencies. This is entirely consistent with MMT analysis. MMT also observes that a falling fx rate is self-correcting to the degree that the balance of trade shift toward exports.

However, this would not greatly aid emerging countries without broad and deep economies that dependent on exporting a commodity whole value is falling. For example, Venezuela would likely be affected by a collapsing oil price than Russia, whose economy is much broader and deeper than Venezuela's. Indeed, as President Putin has observed, the fall in oil prices is a blessing in disguise since Russia has known for a decade at least that the economy is to tilted toward export of natural resources and needs to be broadened and deepened further by recapturing lost industrial potential and expanding its domestic consumer economy.

MMT also shows how a country can use currency sovereignty to address such issues. For example, Russia was pegging its currency to the USD, threatening a run on its foreign exchange reserves, so it correctly chose to drop the peg and float the ruble. This gives the central bank some leeway in curbing speculation by intervening on occasion to drive up the cost of speculation by squeezing the shorts. The ruble also gained strength at tax time when Russian exporters had to purchase rubles to pay Russian taxes that are only payable in rubles. The firms therefore sold foreign currency obtained through trade in order to meet their tax obligation. As MMT says, taxes drive a currency by creating demand for it.

Furthermore, as Warren Mosler has pointed out, governments control the own rate in setting the policy rate and controlling the yield curve if they choose by setting price and purchasing the quantity necessary to set those yields. Government also influence the price level through the prices they pay in markets, using their currency to transfer resources owned by nongovernment for the public purpose. And as the Great Depression and the aftermath of the recent crisis has shown, government has powerful tools that can be used to address emergencies through both the central bank and fiscal policy.

Then Jesse reveals his ideological concern.
Technically Russia could not become insolvent in rubles, because they could always print more of them to pay all their debts, make purchases, and salary payments. The great caveat in this is that Russia had to maintain a measure of control and enforcement to make that principle 'stick.'

And this is what probably makes MMT inadvertently statist, and dangerous. That is because this belief only works within a domain in which the state exercises complete control over valuation.
So is the "fatal flaw" in MMT that is is too "Keynesian" and not Austrian enough?  :)
I suppose that there are many other things in MMT that are correct, as it seems to be quite the usual thing in many ways, but there is an important exception in the assertion that the state has no limit to its power to set value, because that is exactly what is implied in the canard that a sovereign cannot default in its own currency. Technically it cannot because it can always print more than enough pay off debts and make more purchases. But it can create money in such a way as to break the confidence of the market, and call its valuation into question. And this is a de facto default.
De facto default in the typical Austrian rejoinder to what Austrians see as too much government control and currency profligacy. The error of this is pointed out above. MMT readily admits that there are operational constraints on a currency sovereign but insolvency and forced default are not among them. They are rather the availability of real resources and currency stability, which involves both the price level and fx rate.

Moreover, not all currency instability is the result of "debasement," as some seem to think. The West, President Obama and Prime Minister Cameron, for instance, have stated or strongly implied that the sanctions directed at Russia are design to destabilize the economy and as a consequence the political situation in Russia, with a few to regime change, just as in Cuba and Iran and now Venezuela also. This is intentional application of force majeure that is sufficient legal reason not to honor debts.

Jesse's Café Américain
The Great Fallacy at the Heart of Modern Monetary Theory
Jesse

20 comments:

Ryan Harris said...

An MMT assumption is that the government is the monopolist of the currency. Russia, by allowing their citizens to earn rubles but bank and pay taxes (especially on oil production) in foreign currencies, it creates an unstable system, where citizens engage in herd like behavior and move in and out of the ruble on a whim.
Currencies are supposed to be volatile, it is more of a feature than a bug so long as the government creates a system that ensures demand for the currency and keeps a real floor under it.

I keep coming back to the difference in perception between the norwegians and russians. Almost polar opposite responses yet both currencies have followed similar paths this year. One country views the weakening as an advantage, the other as an existential threat. Different countries, Different Circumstances but similar currency moves, both have very high levels of foreign reserves and both have enormous amounts of pessimism from foreigners about their future.

NeilW said...

The mistake all these people make is that they forget that currency exchanges have to be settled.

That means physical delivery of the currency at T+2.

The majority of traders don't want to do that and so they close and reopen their positions at the end of the trading day.

Therefore the net effect is always due to those that are scared out of overnight savings positions - plus the balance of actual trade.

The monopolist of the currency is down to the power to tax. If you simple tax foreign holdings of people in your own jurisdiction in your own currency. Or better still tax their physical assets in your own currency, then you maintain demand for the currency.

Nearly always the central bank takes entirely the wrong policy approach to the foreign exchange market. It's job is to enable needed transactions to clear, and to ensure that speculative ones fail. With the correct demand/supply view of currency that is easy.

Suggesting that the currency system is somehow a problem because central banks keep screwing up is just like saying that heavier than air flying machines are impossible because the pilots and creators of the first machines didn't know what they were doing.

Now the hyperinflationistas have failed, inevitably they are going to try the currency scare manoeuvre.

They are wrong there as well.

Dollarisation and the shrinkage of a currency area within a country is stopped by imposing and enforcing a greater tax burden in the monopoly currency, and reducing the availability of loans in the currency (if they are not banned for speculation already).

All of which are standard MMT policy suggestions.

Matt Franko said...

Ryan what are the current rates in Norway vs the 17% in Russia?

Might be interesting to watch what happens in each nation if there is a big difference in the policy rates...

Rsp

Matt Franko said...

Ryan look at Iceland rates back when they turned it around quickly back in 08 / 09 they were like 18%...

Now they keep fighting "deflation" by lowering the rates there down to 5% now there and its not helping and not going to help imo.... rsp

Ignacio said...

Matt you are right in Europe the problem is not that bad regardign those ideologies for the common folk, but in practice we got the joke elites in EU-Bundesbank thing who have more real power implementing their "free-market & hard-money" ideology.

So in the end we got it WORSE!

NeilW said...

Pretty much everybody who supports the EU on the left hates 'the nation state'.

Hence why they want to hand it over to a corporate controlled European Union, via one universal currency and with all the workers forced to wander the entire continent in search of work.

It does make you wonder why they want to run a nation state if all they want to do is abolish it.

On the left, a belief in one world idealism is absolutely required if you want to get invited to the relevant parties.

And of course these neo-liberal induced currency crises - all of which are entirely avoidable with the correct policy - allows them to push their fixed exchange rate, one currency view even harder.

Matt Franko said...

"It does make you wonder why they want to run a nation state if all they want to do is abolish it. "

Well that about sums it up... I would point out that the ability to perceive this is an important characteristic between "us" and "them"....

rsp,

Salsabob said...

A pretty good defense of MMT by simply restating its basic tenet that the only constraint is inflation/devalutation. You even touched on how that constraint can be managed, and in some situations, actually advantageous. Two thumbs up.

My only complaint is with your finish of "force majeure." As Jesse reveals his actual motivation to be the typical Austrain swipe at the state, yours is reveal as a swipe against the West. There is no credible evidence whatsoever that the measures directed against Russia are intended for regime change. No evidence whatsoever that the West, certainly the US, even cared much at all about Ukraine's drift until Russia made it their business to make us care by invading another sovereign state and attempting to rapidly change state boundaries in Eurasia - an idea that has proven catastrophic once too often. Most people grasp that if Russia removed its overt military pressure on Ukraine, your so-called "regime changing" measures from the West would be soon after removed, likely removed with substantial sighs of relief in DC, London and every other Western capitals.

Could you be adopting the de facto default of the typical Austrian rejoinder with just the slight modification of adding the adjective "US/Western" to "government control?" I, for one, am not sure how that actually helps spread understanding and acceptance of MMT.

Tom Hickey said...

The nation state and attendant legal concepts such as national sovereignty in international law is a modern European construct that many would agree is outliving its usefulness in a globalizing social, political and economic system. Scholars disagree over dating the origin of the concept, but the majority puts the contemporary version as emerging in 19th century Europe.

The nation state is neither a natural or permanent fixture of human interaction. The concept of a nation is naturalistic to the extent that geographical boundaries corresponded to an ethnic stock with a common language (or root language) and cultural symmetry. In this sense a "nation" (from Latin "born") was the culmination of the family, clan, tribe, group of tribes process of historical development.

But this natural process is quite different from both the contemporary construct of the nation state and the composition and geographical boundaries of contemporary nation states. A great deal of conflict has arisen out this, which is one reason that political scientists question the usefulness of the contemporary nation state construct as the basis for international law and geopolitics.

The second issue suggesting that the nation state is becoming obsolescent if not yet obsolete is the rise of translational institutions both economically and politically. Where sovereignty begins and ends is becoming increasingly difficult to determine with precision.

This was revealed, for example, in the debate over the monetary construct underling international trade at Bretton Woods, which has been a sore subject since, with several revisions already and many calling for a complete overhaul now as the great powers of WWII are being added to and starting to be replaced by BRICS, who resent the dollar dominance imposed at Bretton Woods rather than the bancorproposed by J. M. Keynes and E. F. Schumacher, for instance.

Tom Hickey said...

My only complaint is with your finish of "force majeure." As Jesse reveals his actual motivation to be the typical Austrain swipe at the state, yours is reveal as a swipe against the West. There is no credible evidence whatsoever that the measures directed against Russia are intended for regime change.

force majeure is a legal concept that would have to be decided by courts having jurisdiction. Russian courts could decide that sanctions constitute force majeure and postpone payment or void the debt of the Russian state and domestic entities to foreign parties. Russian entities could also bring suit in other jurisdictions. This is beyond my job description, but form what I read there is precedent suggesting that force majeure could be sustained this case, even by Western-dominated courts.

A whole range of facts would be marshaled on both side, but it looks to me like statements that both Obama and Cameron have made are as revealing as statement made about "enhanced interrogation" by Bush and Cheney. In the later case the court would have to decide whether Bush and Cheney's public admission of connection with enhanced interrogation is prima facie evidence that they were aware of and approved torture as defined by US law and international law and treaties.

Conclusion

The imposition of sanctions may mean that an innocent party in a contractual relationship that is affected by sanctions is in a position to argue that the contract is at its end through no fault of his own. The wording and nature of the affected contract, and the terms of the sanctions in each case are, of course, critical. And parties should endeavor to take the necessary steps to verify whether they are entitled to seek derogations or whether they can obtain authorizations from the relevant authorities which may permit continued performance of a contract potentially affected by the impact of sanctions.


Lexology, Russian focused sanctions: contracts, force majeure and frustration under English law



Tom Hickey said...

No evidence whatsoever that the West, certainly the US, even cared much at all about Ukraine's drift until Russia made it their business to make us care by invading another sovereign state and attempting to rapidly change state boundaries in Eurasia - an idea that has proven catastrophic once too often. Most people grasp that if Russia removed its overt military pressure on Ukraine, your so-called "regime changing" measures from the West would be soon after removed, likely removed with substantial sighs of relief in DC, London and every other Western capitals.

You have either only been reading one side of the story, or else have accepted that story as true after considering all available evidence. The story is much more involved than you represent. The evidence itself is controversial, not to mention the spin.

Force majeure is a legal concept and the issues surrounding a case would have to be decided by a court with jurisdiction.

The point I was making is that in the case of sanctions, it is not the fault of the state being attacked economically that the currency is being adversely affected. My point is that in such cases it illogical to assert that MMT has overlooked some key factor in monetary operations, or that the currency crisis has been caused by the state that is being attacked.

Therefore, the Russian example is irrelevant to this argument.

I brought up force majeure as a legal remedy specifically for sanctions, in addition to financial and economic actions that MMT might suggest for addressing any currency crisis or potential crisis.

NeilW said...

"The point I was making is that in the case of sanctions, it is not the fault of the state being attacked economically that the currency is being adversely affected."

What's funny in the Russian situation is that the move was because the US has insisted that it shrinks its economy by refusing to rollover USD loans. That created a demand for USD, which was given to the US banks and destroyed.

Hence a shortage of USD and a surplus of roubles - in the short term.

Of course the US has now shrunk its loan base and its banks income potential.

Matt Franko said...

Tom its not the sanctions that affect the currency exchange rate for Russians. .. The minimum exchange rate for roubles in Russia is set by Russian CB and Russian banks... Russian fiscal agents.

The sanctions can effect trade only....

If the sanctions could in any way cause US bank loan losses then there would never be any sanctions....

Any USD loans at risk like this are not issued by US banks but rather are issued by entities external to US banks probably external to the US entirely..... rsp

Tom Hickey said...

Imposition of sanctions reduces saving desire in the attacked currency, especially when sanctions involve banking and finance, if only owing to increasing uncertainty.

This is an indirect effect of an attack instead of a direct attack by dumping the other nation's currency in the market, but it is also one of the motivations for an economic attack as an intended consequence.

The is extent of the attack on Cuba and Iran, for example. The US has not gone to banking sanction wrt Russia yet, but it is jawboning about increasing sanctions if Russia is non-complaint with US demands to put further pressure on "Putler."

See Politico, Is Obama destroying the Russian economy? — Sanctions helped sink the ruble, officials say privately.

Matt Franko said...

Just because morons say something Tom does not mean that is the way it really works...

The typical response to chaos like the sanctions have fomented is for business entities to stop entering into financial agreements with each other I would agree with you as far as that goes...

But if it were the case that JPM had $50B of loan assets at risk somehow in this no way sanctions happen...

Russia's current "problems" (which btw they are not even problems in real terms imo...I think you'd agree...) have more to do with oil price collapse and European austerity spreading in from the periphery to the core at the same time as the sanctions imo...

They will get right out of this situation if they keep the rates up at 17% just like Iceland (18%) did and this has the resultant effect of significantly increased domestic fiscal flows ....thru interest income..

And watch Norway in contrast they just LOWERED rates from 1.5% to 1.25% there ... I'd look for Russia to recover domestically faster than Norway cet par if this rate environment differential stays the same...

And nobody in Wash DC or Moscow will even know what really happened imo....

rsp.

Tom Hickey said...

Investors are shinning the RUB, welathy Russians are taking their liquid assets and leaving (good riddance), and the public is dumping RUB savings and either converting to a strong currency, or hoarding goods. This is increasing the supply of RUB.

The 17% policy rate will take time to work and is not immediately effective other than in shutting down borrowing for investment unless the government subsidizes borrowing for investment, which it is doing.

In my view, Russia should set the policy rate at zero, use FF to stimulate economy in every way possible to broaden and deepen the economy, diversify away from dependence on both Western trade, and provide a JG for those involuntarily unemployed. If need be, Russia can impose rationing on scarce goods that need to be imported until Russia can address the shortfall domestically or through new supply channels. They can also impose capital controls and wage and price controls, too. The US took such measures during WWII.

Russia also hold the sledge hammer of energy supply over Europe. This is a much more powerful economic weapon than sanctions if push comes to shove and Russia sees it as in its interest to destroy the European economy by shutting off the spigot. But Putin is subtler than that and likely won't need to wield it, or even threaten it. The Europeans know that they are screwed if Russia turns off the pipelines or even significantly decreases the flow.

The Russian economy is among the top ten, and Russia is a resource rich country. It's population is the best educated in the world. They have no real issues they cannot address with existing resources and MMT principles now that that they have floated the RUB. Zero.

Putin and XI both understand that if Russia goes down, then NATO is on China's western border. Xi is not going to let that happen, so Russia can pretty much bank on Chinese assistance, which they have already pledged.

If anyone should be concerned it is the Europeans. They are looking into the abyss of deflation, economic decline, and energy starvation.

MRW said...

"No evidence whatsoever that the West, certainly the US, even cared much at all about Ukraine's drift until Russia made it their business to make us care by invading another sovereign state and attempting to rapidly change state boundaries in Eurasia "

You're joking, right?

Last February the democratically elected president of the Ukraine said that he was not going to trying to join the EU (which would have required that Ukraine give up its sovereign currency) and Victoria Nuland of the US State Department was secretly recorded talking to the US Ambassador to the Ukraine telling him that she had the person ("Yats is our guy") she wanted to be the new president of the Ukraine. Nuland helped organize the Maidan protests and was photographed there handing out food. When the US Ambassador said that the EU might object, she famously said, "Fuck the EU." You don't remember that?

The people in Crimea, seeing the writing on the wall with the protests in which the idea that Russian was going to be outlawed as a language, VOTED in a special election to return to Russia and asked for Putin' help. It was a no-brainer decision for the Crimeans. As reported at the time, the army would get 5X the salary by returning to Russia. ($200/mo to $1,000/mo.) Pensions would be 2X to 5X higher. Crimea has been part of Russia for centuries. It was Russia's summer "White House" for 200 years. The only reason Khrushchev gave it up was because his Ukrainian mistress asked him to.

If you think Russia acted unilaterally, you need to do some digging, because you've bought the MSM kool-aid, and they are effing ignorant. My great-great-great, and great-great aunts were governesses to the court of the Czars and spent their summers in Crimea attending to their wards for over 60 years until 1905. Crimea has always been Russian.

Random said...

Russia should implement 100% land value taxation in rubles and a job guarantee. Also shut off the gas. The government needs to get bigger and pump more money around.

Tom Hickey said...

I expect their new Chinese partners will clue them in on this.

Tom Hickey said...

BTW, the Chinese have a name for the JG or BIG as the case may be. It's called "the iron rice bowl." The government knows that it's not safe to "smash the iron rice bowl" and risk unrest by creating a lot of idle workers that face destitution.